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  Investment Strategy Update, July 2017

Investment Strategy—Positioning for Relative Opportunities

Global equity markets continued to climb higher in the first half of 2017 as earnings recovered, and momentum and positive sentiment helped markets shrug off concerns regarding the new U.S. administration’s ability to execute on its policy agenda of lighter regulation and looser fiscal policy. We expressed our concern in our last letter that there remains significant uncertainty regarding actual policy implementation, noting that our analysis continues to focus on the fundamentals of the macroeconomic landscape, while considering how such fundamentals may change in response to policy actions. As a result, last quarter we shifted portfolios away from a value-bias to a neutral style posture while also favoring Non-U.S. equity exposure, with the goal of reducing the cyclical sensitivity of our portfolios while also seeking to benefit from cheaper valuations abroad, which we also expected to benefit from the tailwinds of a weaker U.S. dollar.

In order to adapt to evolving market conditions, the Wilshire Funds Management Investment Strategy Committee meets at least quarterly to assess a variety of factors, including but not limited to economic, fundamental, technical, and risk indicators. This quarter, we are continuing to increase foreign equity exposure while also reducing credit risk, which will result in a slight increase in equities and a more meaningful increase in government bonds. We continue to believe that the current economic landscape warrants lower interest rates and lower expected returns across asset classes. We remain consistent in our slightly cautious risk posture, most specifically through an underweight in equity risk in favor of alternative investments. Although our views are directly reflected in our portfolios, we have also included a broad review of the changes in our views since April, with a summary of our rationale and supporting exhibits in the proceeding sections. We will continue to keep you apprised of our market perspectives and positioning.

 

Asset Class April Change July
Fixed Income vs. Equity Overweight Neutral
Alternatives vs. Equity Overweight Overweight
Alternatives vs. Fixed Income Neutral Neutral
Duration vs. Bloomberg Barclays Capital Aggregate Bond Index Underweight Underweight
Credit vs. Government Overweight Underweight
Investment Grade vs. High Yield Neutral Neutral
High Yield vs. Bank Loans Underweight Underweight
Non-U.S. vs. U.S. Fixed Income Underweight Underweight
Large Cap vs. Small Cap Equities Overweight Overweight
Growth vs. Value Equities Underweight Neutral
Global ex-U.S. vs. U.S. Equities Overweight Large Overweight
Emerging Markets vs. Developed Equities Overweight Overweight
Global REITS vs. Global Equities Neutral Neutral
Commodities vs. Global Equities Neutral Underweight

 

Asset Class Change View Summary of Rationale
Fixed Income vs. Equity Neutral
  • Our prior overweight to fixed income was implemented through an overweight to high yield as a substitute for equity risk, with the objective of reducing equity beta while earning additional yield in an environment of lower expected returns. Given the dramatic narrowing of high yield spreads over Treasuries, we see limited upside in high yield today, and are now redeploying this exposure back into equities.
  • While this move from high yield back into equities represents a minor increase in risk, we seek to mostly offset this risk by underweighting corporate bonds in favor of government bonds.
Alternatives vs. Equity Overweight
  • We maintain our overweight in alternatives, which is specifically implemented through equity hedge strategies. This continues to serve the objective of reducing equity beta and introducing more alpha- oriented strategies that can benefit from the additional breadth of short positions.
Altnernatives vs. Fixed Income Neutral
  • We continue to believe that interest rates will be low for longer, given modest levels of inflation and economic growth on a global basis, and we believe that fixed income will continue to serve as one of the best sources of diversification to equity risk.
Duration vs. Barclays Capital Aggregate Bond Index Underweight
  • Our decision to remain underweight duration is more in response to rising duration exposure in the benchmark, and we have decided to be only slightly shorter than the benchmark, as we still find duration exposure to be complementary to our equity risk exposure.
Credit vs. Government Underweight
  • Given the dramatic narrowing of corporate bond spreads over Treasuries, we see limited upside in corporate bonds today, and are now favoring government bonds. This decision is also meant to serve as a ballast to our equity risk and non-U.S. equity exposure.
Investment Grade vs. High Yield Neutral
  • Cross-sectional valuations do not warrant a deviation from neutral posture.
High Yield vs. Bank Loans Underweight
  • Bank loans offer similar yield spreads relative to high yield, with significantly less volatility.
Large Cap vs. Small Cap Equities Overweight
  • Consistent with our relative underweight to equities, large caps exhibit lower equity beta.
Growth vs. Value Equities Neutral
  • The current valuation dispersion between growth and value is not materially different relative to the long-term history of this measure, and the performance of value vs. growth is largely dependent on the outcome of government policy, which is too uncertain for our risk budget.
Global ex-U.S. vs. U.S. Equities Large Overweight
  • We are witnessing economic momentum in foreign economies relative to the U.S., and foreign equity are more attractive on a valuation basis. The USD remains overvalued relative to the euro, yen, and pound, which may create an additional tailwind for foreign returns in USD.
Emerging Markets vs. Developed Equities Overweight
  • Valuations remain considerably more compelling on a relative basis.
Global REITS vs. Global Equities Neutral
  • Cross-sectional valuations do not warrant a deviation from neutral posture.
Commodities vs. Global Equities Underweight
  • Inflation appears to be rolling over, and energy prices are facing resistance in the face of rising production. We have also witnessed technical deterioration in oil prices.

 

Macroeconomic Outlook

  • Our assessment of the macroeconomic landscape indicates moderating economic growth and inflation on a global basis, as shown in Exhibits A and B.
  • Developed markets remain relatively stable in terms of GDP growth on a normalized basis, and we are still seeing below average growth in emerging markets, albeit faster than in developed markets.
  • On a forward looking basis, when we look at the Purchasing Manager Index (PMI), which is an indicator of economic health in the manufacturing and services sectors of a country or a region, we are witnessing positive economic momentum in the foreign economies of both Eurozone and Japan relative to the U.S. (Exhibits C and D).
  • On a global basis, measures of inflation are mostly in-line or slightly below historic averages.
  • Given that global growth and inflation remain moderate, we believe that global central banks will be slow to tighten monetary policy.

Exhibit A: Country GDP Growth (Normalized, 15 years)

Exhibit A: Country GDP Growth (Normalized, 15 years)

Source: Bloomberg

Exhibit B: Country CPI Growth (Normalized, 15 years)

Exhibit B: Country CPI Growth (Normalized, 15 years)

Source: Bloomberg

Exhibit C: PMI Surveys — Eurozone vs. U.S.

Exhibit C: PMI Surveys - Eurozone vs. U.S.

Source: Bloomberg

Exhibit D: PMI Surveys — Japan vs. U.S.

Exhibit D: PMI Surveys - Japan vs. U.S.

Source: Bloomberg

Exhibit E: U.S. Consumer Price Index

Exhibit E: U.S. Consumer Price Index

Source: Bloomberg

Exhibit F: Inflation Measures

Exhibit F: Inflation Measures

Source: Bloomberg

  • U.S. economic growth continues to disappoint, with first quarter GDP growth coming in below expectations at 1.4%.
  • As shown in Exhibits E and F, the recent rise in headline inflation (CPI YOY Index [green]) has rolled over, as have measures of both core inflation (CPI XYOY Index [orange]) and Personal Consumption Expenditures (PCE DEFY Index [blue]).
  • The most recent month-on-month reading for CPI was 0.0% in March, as energy prices continued trend lower. It is important to note, however, that non-energy related commodity prices also continued to soften which weighed on core inflation (0.1% for June). Year-on-year headline and core inflation now sit at 1.6% and 1.7%, respectively.
  • U.S. Personal Consumption Expenditures now sit meaningfully below the Fed’s 2% target, at 1.4%. This represents one of the Fed’s most favored measures of inflation, and based on this indicator, we would expect the Fed to be cautious with its tightening policy so as not to stymie economic growth and inflationary pressure.
  • We maintain our view that given the very low bond yields in developed Europe countries and Japan, which continued to support global demand for dollars, it is challenging to envision a material rise in interest rates in the U.S.
  • We continue to expect a moderating economic growth environment in the foreseeable future, and therefore, we believe that the current economic landscape warrants lower interest rates and lower expected returns across asset classes. As a result, we have maintained our more cautious positioning, most specifically in our equity allocations, where we remain underweight in portfolios where we have the ability to allocate to alternative investments.

Fixed Income Outlook

  • We have moved to a neutral position in fixed income relative to equities, as we are no longer replacing equity risk with credit risk.
  • Given ultra-low foreign developed market bond yields, we favor domestic fixed income over global fixed income, however we recognize that further weakness in the dollar would serve to benefit foreign fixed income.
  • From an interest rate risk perspective, we maintain a slightly shorter duration exposure relative to each portfolio’s benchmark exposure, as the benchmark’s duration has been gradually rising. We have continued to reiterate our belief that rates will remain low and interest rate sensitivity may still provide a diversification benefit, although more limited, in the event that the economy and inflation continue to grow at a moderate pace.
  • We continue to believe that the economic data is broadly inconsistent with restrictive monetary policy, and the market is starting to price in a considerably lower probability that the Fed will raise interest rates further in 2017. Exhibit G below shows that the market is now pricing in a lower probability (approximately 43%, down from nearly 80% in April) of one additional rate hike by December.
  • With respect to credit markets, given the significant narrowing of corporate bond yield spreads over Treasuries, we no longer have a favorable view of credit, and are repositioning portfolios to be underweight credit and overweight government bonds.
  • The decision to overweight government bonds is also meant to serve as a ballast to the slight increase in equity exposure.

Exhibit G: Futures Implied % Probability for One Rate Hike

Exhibit G: Futures Implied % Probability for One Rate Hike

Source: Bloomberg data
*Current Fed Funds is 1.00 – 1.25%

Equity Outlook

  • Our equity heat map expresses positive and negative signals through green and red indicators, respectively.
  • On a cross-sectional basis (Exhibit H), we observe that U.S. equities remain more than one standard deviation more expensive relative to their non-U.S. developed market counterparts. As noted earlier, we are also witnessing economic momentum in Europe and Japan relative to the U.S. Although we have already witnessed material USD weakness in the second quarter, we continue to find the USD to be overvalued against major developed market currencies, which may lead to continued performance tailwinds for foreign equity allocations if we see weakness in the U.S. dollar. Given the positive alignment for foreign equities across valuations, economic momentum, and currency valuations, we believe that moving to a large overweight posture to foreign equities versus U.S. equities will provide the best opportunity to outperform on a relative basis.
  • We have moved past an earnings recession, and earnings forecasts for 2017 remain very optimistic—now approximately 9.8% earnings growth for the S&P 500 Index, down from earlier estimates of 13%. As we’ve discussed in the past, these expectations are largely driven by margin expansion, and a recovery in earnings for the Energy sector. When excluding Energy, the expected earnings growth would fall to 3.7% from 6.5% for the S&P 500 Index in Q2 alone.
  • We are also witnessing a high degree of optimism in the technology sector, which represents the second largest contributor to forecasted earnings in Q2. We continue to see considerable risk to this optimism and forecast, particularly given the valuations in this sector.
  • While we are encouraged by the market’s ability to shrug of geopolitical concerns and moderating economic growth, we believe that ultra-low levels of implied volatility, as measured by the VIX Index, remain symptomatic of complacency, particularly in the face of high valuations.
  • We believe that increasing government bond exposure to help offset our equity risk is prudent, given current valuations. We will continue to adapt our portfolios to market conditions and promote diversification to dampen the volatility of our client portfolios with the objective of achieving long-term financial objectives.

Exhibit H: Cross-Sectional Equity Valuations (Forward P/E, 15 Years, Normalized)

Forward PE Relative Z-Score Map

Exhibit H: Cross-Sectional Equity Valuations (forward P/E, 15 years, normalized)

Source: Bloomberg

Important Information
Wilshire Funds Management (“WFM”) is a business unit of Wilshire Associates Incorporated (“Wilshire®”). WFM delivers Wilshire Advisor Solutions, which include models designed to provide a broad range of outcome-oriented investment solutions for advisors to use with their clients.

This material contains confidential and proprietary information of Wilshire. It may not be disclosed, reproduced or redistributed, in whole or in part, to any other person or entity without prior written permission from Wilshire Funds Management.

This material is intended for informational purposes only and should not be construed as legal, accounting, tax, investment, or other professional advice. Past performance does not guarantee future returns. This material may include estimates, projections and other “forward-looking statements.” Due to numerous factors, actual events may differ substantially from those presented.

This material represents the current opinion of Wilshire based on sources believed to be reliable. Wilshire assumes no duty to update any such opinions. Wilshire gives no representations or warranties as to the accuracy of such information, and accepts no responsibility or liability (including for indirect, consequential or incidental damages) for any error, omission or inaccuracy in such information and for results obtained from its use. Information and opinions are as of the date indicated, and are subject to change without notice.

Wilshire is a registered service mark of Wilshire Associates Incorporated, Santa Monica, California. All other trade names, trademarks, and/or service marks are the property of their respective holders.

© 2017 Wilshire Associates Incorporated. All rights reserved.

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Replay Coming Soon

2017 Third Quarter Market Update
  • Presented by: Josh Emanuel, CIO, Wilshire Funds Management
  • Date: Wed., Oct. 18, 2017